Example: Hidden Action

Symmetric Information
•  Consider a risk-neutral principal hiring a risk-averse agent with utility
function 𝑢(𝑤) = 𝑤0.5, disutility of effort 𝑔(𝑒) = 𝑒, and reservation utility
= 9.
• There are two effort levels 𝑒𝐻 = 5 and 𝑒𝐿 = 0.
• When 𝑒𝐻 = 5, the principal’s sales are $0 with probability 0.1, $100
with probability 0.3, and $400 with probability 0.6.
• When 𝑒𝐿 = 0, the principal’s sales are $0 with probability 0.6, $100
with probability 0.3, and $400 with probability 0.1.
• In the case of 𝑒𝐻 = 5, the expected profit is $270, while in the case of
𝑒𝐿 = 0, the expected profit is $70.
Symmetric Information
• When
  effort is observable, the principal can induce an effort 𝑒𝐻 = 5 by
paying a wage that solves:

𝑢() = + 𝑔(𝑒)
 = 142 = 196

• Similarly, the principal can induce a low effort 𝑒𝑒𝐿𝐿 = 0 by offering a

wage

𝑢() = + 𝑔(𝑒)
 = 92 = 81
Symmetric Information
• Given these salaries, the profits that the principal obtains are:
$270 − $196 = $74 from 𝑒𝐻 = 5
$70 − $81 = −$11 from 𝑒𝐿 = 0

• Thus, the principal prefers to induce 𝑒𝐻 when effort is observable.

Asymmetric Information
•  Consider Example 1, but assuming that the principal cannot observe
the agent’s effort.
• In this incomplete information setting, the principal must offer a
salary that increases in profit if he seeks to induce 𝑒𝐻 = 5.
• The principal’s maximization problem becomes:

max {𝑤(𝜋)} 270 − [0.1𝑤(𝜋)1 + 0.3 𝑤(𝜋)2 + 0.6 𝑤(𝜋)3]

s.t: 0.1 + 0.3 + 0.6 − 5 ≥ 9 (PC)
0.1 + 0.3 + 0.6 − 5 ≥
0.6 + 0.3 + 0.1 (IC)
Asymmetric Information
•  Since the principal’s revenue is a constant ($270), he can alternatively
minimize its expected costs

min {𝑤(𝜋)} 0.1𝑤(𝜋)1 + 0.3 𝑤(𝜋)2 + 0.6 𝑤(𝜋)3

s.t. 0.1 + 0.3 + 0.6 − 5 ≥ 9 (PC)

0.5 + 0.5 − 5 ≥ 0 (IC)
where the IC constraint has been simplified.